The alarm bells of the Turkish economy did not ring until May, with inflation at 12.1% and the lira down 18% since the beginning of the year. After all, the central bank had been caught behind the curve several times before, but was puzzlingly given credit by market participants after erratic last-minute rate hikes, so this was seen as “more of the same”. Policymakers who, for years, regularly made reform promises without delivering on them would, it was assumed, sooner or later come up with suitably market-friendly rhetoric to calm investors.
But things did not work out that way. The central bank became invisible and policymakers’ approach only confused investors. US sanctions triggered a sharp lira sell-off which, in the absence of functioning central bank policies, led to a negative spiral with increasing worries over external debt and rising inflation leading to further lira weakness. Banks also came under the spotlight as fears of lower debt rollover ratios, rising non-performing loans and declining capital adequacy ratios created a perfect storm in the financial markets.
To hike or not to hike
The most common question is if, when and by how much the central bank will raise interest rates. In reality, it matters little unless a hike is backed by a credible roadmap to fight inflation. We have seen this on numerous occasions before: each time, the central bank eventually made a decisive sizeable hike, but quickly lost its grip on inflation. Raising rates without a comprehensive policy roadmap will not make a meaningful difference to the two primary goals of a rate hike; lower inflation and a more attractive lira. What is missing from the equation is credibility, and that is something the central bank will have to fight to regain by pursuing and implementing a clear, comprehensive and credible monetary framework.
Knocking at the IMF’s door again?
The sharp lira depreciation led to debates over whether Turkey will soon be knocking at the IMF’s door for financial support. Don’t expect this to happen anytime soon – Erdogan is simply not keen on working with the IMF, and the process of identifying the issues and asking for external help is complicated, with 70% of Turkey’s $466bn external debt in the private sector. Policymakers with no incentive to seek external help would need to wait for financial distress to become more quantifiable before evaluating options.
External financing difficult, but not impossible
External financing needs are too large to ignore, but Turkey’s forward-looking external financing requirements have been within the same $200-230bn range over the past 5 years. What is new this time is the deep erosion in confidence which makes external financing look impossible to source. The $180bn short term debt service requirement is significant, but government debt, banking loans and import credits can still be serviced or rolled over, albeit with unattractive terms. Some of this debt can be paid off by assets held abroad or with cash generated from existing operations. After all, foreign creditors also face the dilemma of not rolling over but not getting paid, or rolling over but ultimately getting paid something.
Current account deficit to decline beyond expectations
In June, the current account deficit saw a surprisingly steep decline, primarily due to a collapse in imports of finished consumer goods, and continuing growth in tourism.
From the financing perspective and assuming a limited improvement in FDIs, minimal fresh external debt, a modest return of portfolio inflows for increasingly attractive Turkish assets, and no further decline in the Central Bank’s already slim net international reserves, one might expect an even lower deficit, which also implies a sharp GDP contraction in the range of 3-5% for the period. Taken together, a total external financing need of $200bn in the next 12 months seems reasonable, with $85-90bn being the most challenging element, thus indicating the size of a possible short-term financing package.
No doomsday for the banking sector
The banking sector is another story. Turkish banks are much stronger than they were during the 2001 crisis, though not totally immune. A short-lived investment grade rating back in 2012-13 led to a 70% increase in banks’ external debt. More importantly, the system generated a surprisingly low non-performing loan (NPL) ratio of only 3%. True, NPL sales and a booming economy helped, but, a more realistic NPL ratio which includes refinanced and restructured loans would be somewhere around 7%. Given much higher rates for new loan originations and a likely slow-down in the economy, this ratio might exceed 10% going forward. Solvency ratios are still high, but lira depreciation will take its toll on capital adequacy ratios (CARs) which stood at 16.3% in June. Nevertheless, fears of immediate solvency issues are exaggerated. It is likely that certain banks will require capital injection but unlikely that the Turkish banking system will collapse as some have suggested.
Down to earth, orthodox policies
There are still too many ifs and whens, and the worst is probably not over when it comes to economic challenges. The course of “Turkey’s economic battle” can be changed, but only by identifying an effective strategy that reflects the realities on the ground, aiming at the right targets and hitting those targets with simple, but well-defined policies. Even if “dark foreign forces” may be unhappy with Turkey’s success, lobbyists may be trying to push interest rates higher and speculators may be attacking the lira, policymakers must simply ignore them and focus on their next move to win this tough battle.
Emre Akcakmak is a portfolio advisor at East Capital